Wall Street Declares The Great Profit Margin Boom Is Finally Over

During the post-financial crisis bull market, corporations have seen profit margins expand as companies cut costs by laying off workers and getting more productivity out of the employees that remain.

But recent data have painted a somewhat conflicting picture, and it looks like by some measures profit margins might be getting slimmer, or “rolling over.”

Following the financial crisis, companies of all sizes saw margins expand. But of late, smaller companies haven’t continued to enjoy record margins, and while larger companies are still seeing margins hold up, as seen in this chart by UBS.

Second quarter GDP data showed that after-tax corporate profit hit a new record high. But following the second GDP estimate released on August 28, The Wall Street Journal’s Justin Lahart highlighted a sometimes overlooked adjustment in the profit margin data.

The “record” after-tax corporate profits exclude two adjustments — one that measures the change in the value of inventory and another that measures depreciation of plants and equipment — and were these items included, corporate profits as a per cent of GDP would be 10% lower than a year ago.

And though the adjusted profits are still near record highs, corporates have clearly seen some decline in profit.

This chart from FRED shows how the unadjusted and adjusted measure of corporate profits have diverged in the last year.

Some economists on Wall Street have also noted this divergence, and when you look “under the hood” of corporate balance sheets, profit margins might be getting squeezed for the first time since the financial crisis.

In a recent note to clients, Sean Darby, chief global equity strategist at Jefferies, said, “Glancing at U.S. nationwide operating margins suggests that margins did indeed peak through 1Q and 2Q of 2014.”

Darby noted three factors that contributed to this contraction: increased capital expenditures, share buybacks, and higher input costs. Darby adds that while the “high degree of U.S. sector oligopolization,” among other factors, will keep costs constrained, “the best of the restructuring and cost cutting is over.”

This chart from Darby shows how multiple expansion for the S&P 500 coincided with with an increase in profit margins, which have recently pulled back.

Dean Maki at Barclays said the catalyst for the squeeze in corporate profit margins is straightforward: labour costs are rising faster than output prices. The broader implications of labour costs rising faster than prices can sometimes be ominous, but Maki writes that, “While sliding profits often lead to recessions, there is nothing that says this is inevitable.”

This chart from Barclays shows how labour costs have outpaced prices this year.

Maki expects the decline in corporate profits to put pressure on companies to raise prices, which the Fed likely welcomes, given that inflation has been running below is 2% target this year.

In her speech at Jackson Hole last month, Fed Chair Janet Yellen said there are still pockets of weakness, or “slack,” in the labour market. And in an optimistic reading, the increase in wages highlighted by Maki could indicate the start of a “virtuous cycle” in the labour market, where employees gain leverage and are able to command higher wages. Or at least, this is how the Fed would want to see this play out.

At Capital Economics, John Higgins also sees profit margins falling in the face of a strengthening labour market, but like Maki, Higgins does not see this fall coming as a collapse that sends the market tumbling.

“The structural forces (e.g. globalization) that have put significant downward pressure on labour’s share of income since the turn of the century are unlikely to disappear any time soon,” Higgins writes. “So the after-tax profit share is unlikely to collapse and trigger the sort of major correction in equity prices that bears anticipate.”

It’s also worth noting that companies in the S&P 500 enjoyed record profit margins in the second quarter.

In a recent note to clients, Goldman Sachs’s David Kostin wrote that he sees profit margins for the S&P 500 remaining near 9%, while consensus estimates are for margins to expand to 10% by the end of next year.

And while the S&P 500 is among the most-referenced stock indexes, and is often considered the “benchmark” index for U.S. equities, it still excludes many thousands of smaller public — not to mention all private companies — possibly painting a misleading picture of the state of corporate earnings.

The S&P 500 is market cap weighted, meaning the largest companies make up the largest percentage of the index. Currently, that means Apple is the largest company in the S&P 500; in its most recent quarter, Apple’s gross margin was 39.4%.

Many have called the current bull market and economic recovery a “balance sheet recovery” that has seen companies repair balance sheets by, again, cutting costs, and engaging in financial engineering to boost earnings and stock prices.

This behaviour has fed the ever-growing profit margins gains.

But if this trend is faltering, and companies start investing in their actual businesses rather than just their financial statements, then maybe we can drop “balance sheet” from the word “recovery.”

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